Combining Active and Passive Investments: More Art than Science
Although the polarizing active versus passive management debate persists, more sophisticated investors have found that the real question is not whether to choose active or passive strategies, but how to combine the best of both approaches in a holistic way to seek the most beneﬁcial portfolios for clients. This newfound middle ground hinges on a new deﬁnition of what it means to be an active investor.
While historically, active management referred to individual security selection, today, with an unprecedented number of investment tools at their disposal, investors seek alpha at the asset class, country, sector or even industry level. Furthermore, smart beta strategies that oﬀer a hybrid path — blending the alpha-generating potential of active management with the low cost of passive approaches — have gained a following.
How you combine active and passive strategies for your clients depends on everything from your market outlook to your investing philosophy. Other factors that may drive your decision to use one strategy over another include sensitivity to fees, diversiﬁcation, and the pursuit of alpha maximization.
Figure 1: The Definition of “Active Investing” Is Changing
Here we share ideas for combining active and passive strategies that we have seen implemented by our financial advisor and institutional clients.
Fee Reduction and Tax Efficiency
Investors seeking to minimize fees and tax liabilities may consider emphasizing index products.
Use passive strategies in the “core” and active managers in the growth and value styles.
Split the diﬀerence in each style box between active and passive, providing an opportunity to reduce fees while continuing to seek alpha.
Be “active in alternatives” to augment a passive equity and bond core.
Replace active managers with smart beta strategies, but gain access to factors that active managers target and save on fees.
Index investments may provide increased diversification to portfolios concentrated in a small number of individual stocks, or they may be used to round out a fixed income exposure.
Create flexibility in the core for diversification, stability and income and select active managers with expertise in less efficient sectors to add additional diversification.
Purchase individual stocks in the large-cap space based on defined screens, e.g., income, growth, etc., but use indexes for asset classes that are more difficult to analyze, such as small caps and emerging markets.
The pursuit of alpha maximization may be achieved by mixing active and passive investments based on market eﬃciency and managers’ historical ability to generate alpha in the asset class.
Use passive exposure to manage traditional asset classes with a tactical, multi-asset-class core holding.
Use a passive holding as the core of the allocation and pursue alpha through active country, sector or industry rotation.
Choose to be active when the conditions are right or when an asset class is potentially mispriced.
· Low stock correlation
· High dispersion
· Significant breadth
· Low sell-side analyst coverage
· High quality of financial reporting
· Dispersion of active manager returns
· Long-term average percent of outperforming managers
· Declining interest rates
Identify not only whether to be active in an asset class, but also how to be active in each.
Smart Beta strategy does not seek to replicate the performance of a specified cap-weighted index and as such may underperform such an index. The factors to which a Smart Beta strategy seeks to deliver exposure may themselves undergo cyclical performance. As such, a Smart Beta strategy may underperform the market or other Smart Beta strategies exposed to similar or other targeted factors. In fact, we believe that factor premia accrue over the long term (5-10 years), and investors must keep that long time horizon in mind when investing.
Investing involves risk including the risk of loss of principal.
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Asset Allocation is a method of diversification which positions assets among major investment categories. Asset Allocation may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss.
Actively managed Fund does not seek to replicate the performance of a specified index. The Strategy is actively managed and may underperform its benchmarks. An investment in the Fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the Fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment. Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations.
Investments in small/mid-sized companies may involve greater risks than in those of larger, better known companies.
Foreign investments involve greater risks than US investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.
Investing in REITs involves certain distinct risks in addition to those risks associated with investing in the real estate industry in general. Equity REITs may be affected by changes in the value of the underlying property owned by the REITs, while mortgage REITs may be affected by the quality of credit extended. REITs are subject to heavy cash flow dependency, default by borrowers and self-liquidation. REITs, especially mortgage REITs, are also subject to interest rate risk (i.e., as interest rates rise, the value of the REIT may decline).
Investing in high yield fixed income securities, otherwise known as “junk bonds”, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
There are risks associated with investing in Real Assets and the Real Assets sector, including real estate, precious metals and natural resources. Investments can be significantly affected by events relating to these industries. Investments in asset backed and mortgage backed securities are subject to prepayment risk which can limit the potential for gain during a declining interest rate environment and increases the potential for loss in a rising interest rate environment.
Issuers of convertible securities tend to be subordinate to other debt securities issues by the same issuer, may not be as financially strong as those issuing securities with higher credit ratings, and may be more vulnerable to changes in the economy. Other risks associated with convertible bond investments include: Call risk which is the risk that bond issuers may repay securities with higher coupon or interest rates before the security’s maturity date; liquidity risk which is the risk that certain types of investments may not be possible to sell the investment at any particular time or at an acceptable price; and investments in derivatives, which can be more sensitive to sudden fluctuations in interest rates or market prices, potential illiquidity of the markets, as well as potential loss of principal.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.
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